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CHALLENGES FOR ISLAMIC BANKING IN INDIA

By

Dr Shariq Nisar
(Author, PhD in Economics, works with Idafa Investments Pvt. Ltd, Mumbai, India. He can be
contacted at shariqnisar@yahoo.com)

Introduction
Financial arrangements constitute an integral part of the process of
economic development. A growing economy requires a progressively rising
volume of savings and adequate institutional arrangements for the mobilisation
and allocation of savings. These arrangements must not only extend and expand
but also adapt to the growing and varying financial needs of the economy.
Perhaps it is due to these reasons that the Government of India has asked the
RBI to look into the matter of Islamic finance. A well-developed and efficient
capital market is an indispensable prerequisite for the effective allocation of
savings in an economy. A financial system consisting of financial institutions,
instruments and markets provides an effective payment and credit supply
network and thereby assists in making best use of a countrys financial
resources.
Imbued with a high level of concern for equity and justice, a consciousness
of differentiating the lawful (halal) from the prohibited (haram) and a sense of
responsibility towards the weaker sections of society, Islamic banking began its
modest operations in a small town in Egypt in the early sixties. Since then there
has been no looking back for it. In fact, with each passing day it grew stronger
and stronger. In certain quarters, it is believed that the oil boom in the midseventies led to the starting of Islamic banking practices but the facts and history
do not support this hypothesis. Nevertheless, it cannot also be denied that the oil
boom did help Islamic financial institutions in the Arabian Gulf to flourish. The
seed of Islamic banking has however been sowed well before anybody could
think of the oil boom in the Gulf region. Moreover, the concept of Islamic
economics (a precursor of Islamic banking) had come not from the Arabian Gulf

but from the Indian subcontinent. In fact a failed attempt to establish Islamic
banking in Pakistan during the mid-fifties also confirms this claim.

Islamic Finance in India

Indias endeavors in the field of Islamic banking and finance have been
beyond routine experimentation. Major attempts have been made in this direction
under the format of cooperatives or trusts. Under the latter the most popular legal
format adopted by Indian Muslims is that of the Muslim Funds. The first of these
was established in 1934. These Funds are mostly found in the belt of Muslim
concentration in the North of the country. According to the information provided
by the Federation of Interest Free Organization (FIFO), there are more than 130
Muslim Funds in the country. FIFO acts as their apex body in policy-making,
liquidity arrangements, staff training and making representation to the
Government.
These Muslim Funds, cooperative credits and welfare societies are nonprofit institutions and were began either out of the need to rescue people from the
usurious moneylenders or out of a concern for the economically backward and
downtrodden.
Much latter, from early 1980s, Muslims started venturing into profitoriented financing. This was made possible for three reasons; firstly, by that time,
they had gained some expertise through successful running of non-profit financial
businesses; secondly, the Islamic financial movement had gained momentum
throughout the Islamic world and; thirdly, the new economic policy initiated in
early 1990s focusing on liberalization, privatization, and globalization (LPG) had
opened new vistas of opportunities for them.
The decade of the 1990s saw proliferation of Islamic NBFCs. However, the
Governments abrupt decision to introduce large-scale regulatory changes in the
non-banking financial sector did not augur well for the entire non-banking finance
sector. The Islamic NBFCs appeared to have been more affected because of the
distinct nature of their business and religious constraints in approaching

conventional avenues of finance (interest based-financing) available to other

financial institutions. In that fast-changing regulatory environment, conventional
NBFCs preferred keeping their monies in commercial banks an avenue that
was not available to Islamic financial institutions - than risk the same in business
ventures. On the other hand the small size of Islamic NBFCs, the absence of a
lender of the last resort besides their naive and complacent attitude towards the
regulation also contributed in fair measure to their doom.

The Prospects
Islamic financial institutions are now operating in over 75 countries.
Estimates suggest that the overall Islamic finance industry, which includes
Islamic banking, non-banking companies, mutual funds, leasing, real estate
investment and stock market investment as well as charitable financial
institutions, has grown 40-fold since the 1980s. Taking into account 15 percent
annual growth of the industry during the last two decades, even a conservative
estimate will put the Islamic finance sector size beyond $ 1000 billion.
Dow Jones Islamic Market Index, which tracks over a thousand companies
from all over the world has launched over forty Islamic indices catering to its
Muslim clientele. FTSE offers Islamic indices services in US, Europe, the Pacific
Basin and South Africa. Most of the large western financial institutions have their
own Islamic subsidiaries or Islamic "windows" or products aimed at their Muslim
clientele. Scores of western banks such as ANZ Grindlays, Chase, Citicorp,
HSBC, UBS and Morgan Stanley are offering shariah compliant products and
services. Statistics from the International Association of Islamic Banks suggest
that assets managed by Islamic banks have grown quite substantially during the
last few years.
Besides being the worlds second most populous country India is also the
worlds second most populous Muslim country. It is Asias third largest and one of
worlds fastest growing economies. Its Muslim population is estimated to be
between 160-200 million. There are several districts where Muslims constitute a

majority and in a number of industries Muslims have traditionally maintained a

larger presence. Since the last two decades, India has continuously managed an
average saving rate of above 20 percent of the GDP. Considering their relative
economic backwardness even a 15 percent saving rate for Muslims would place
over Rs. 40 billion of investible resources with them annually. Besides, there are
properties worth billions under the control of Awqaf (Trusts). Zakat (2.5% tax
imposed on the wealth of rich people for distribution among the poor and
destitute) potential of the Indian Muslims still remains largely untapped and
underutilized. Indians working in Middle East and Middle Eastern companies
flush with petrodollars can also be a good source of financial resources for Indian
financial institutions offering Islamically permissible financial services.

The Problem
Indian banking laws do not explicitly prohibit Islamic banking but there are
provisions that make Islamic banking an almost unviable option. Banks in India
are governed under the Banking Regulation Act 1949, Reserve Bank of India Act
1934, Negotiable Instruments Act 1881, and the state and central Co-operatives
Acts. One of the most distinguishable features of these Acts is that they define
Banking in such a way that Banks can accept deposits from the public only for
further lending. A number of sections such as section 5 (b) and 5 (c) of the
Banking Regulation Act 1949 prohibit banks from investing on profit and loss
sharing (PLS) basis. Further, section 8 of the Banking Regulation Act 1949 reads,
No banking company shall directly or indirectly deal in buying or selling or
bartering of goods
Besides India is among the countries which explicitly provide deposit
guarantee to banks depositors up to a value of Rs. 0.1 million through the
Deposit Insurance and Credit Guarantee Corporation (DICGC). Government also
interferes on the assets side by asking banks to provide concessional credit to
certain priority sectors.

Some other factors that help in stealing the shine of Islamic banking are
the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) requirements.
These together eat up about 30 percent of the banks total deposits. Adding to
this priority sector lending leaves banks with very little capital, which they can
invest in earning non-interest income.

The Solution
Besides banking, Indias financial system also comprises Non-banking
Financial Companies (NBFCs), Mutual Funds, Insurance Companies and
Developmental Institutions. NBFCs, Mutual Funds and Insurance are the sectors
where one can think of applying Islamic principles of finance without much ado.
However, considering the initial capital requirements, NBFCs look like the best
available option because of easier entry norms, lower capital requirements, lower
regulation and flexibility in registration and functioning.
On its own part, Government can allow some public sector banks to come
out with a scheme under which, instead of paying interest to its depositors, it will
agree to share profits earned out of actual investments in activities like trading in
equities, financing infrastructural projects and other core business activities.
Needless to mention, some filtering may be required in these sectors to keep out
segments like financial companies, vulgar entertainment, tobacco etc; but there
would still be a huge basket of investment opportunities left. Authors own
research clearly shows that in any given quarter nearly fifty percent companies of
BSE 500 qualify on strict Islamic finance parameters. Banks can freely invest in
these securities and earn handsome profits. Simultaneously, Government can
also allow private mutual funds to launch schemes that meet the religious
requirements of Muslims. This will not only attract capital from within India but
also from the capital abundant region of the Middle East.